What Caused The Fall Of Lehman Brothers In 2008?

Summary:In June 2010, your author was able to interview
Larry McDonald, author of A Colossal Failure of Common Sense, during the
2010 European Business Summit in Brussels, Belgium. Mr McDonald has
written and commented in great detail about the fall of Lehman Brothers
in 2008. This page details that interview.

Larry (known as Lawrence McDonald in the USA) participated in the financial services discussion in the 2010
European Business Summit
in Brussels. Their debate included brief conversations relating to
financial education for the population, the difficulty of finding work
in Wall Street and investment banks, the amount of leverage in the
financial system and much more.

As we all know, the failure and fall of Lehman Brothers in 2008
and the financial crisis more broadly, was caused by many different
problems in the banking world. These reasons include sub-prime
mortgages, an interconnected world of derivative contracts, poor
understanding of the risks being taken and much more. Many of these
issues played out in Lehman Brothers and are described in Larry's book, A
Colossal Failure of Common Sense.

In our interview, we discuss a number of the broader issues. EBS
is really about European government policy making, so we had to discuss
some of the more related topics of regulators and regulations, wages and
bonuses.

As interesting as this interview was, Larry was even more interesting
off camera before and after (apologies for not catching more of it). He
has some strong views on the increase in
prop trading
by the big investment banks, the impact this had on their business
models and their relationships with clients. We also discussed at some
length the role of pension funds and why their insistence to company
boards of directors that they use limited amounts of borrowing (broadly a
very sensible idea) opens them up to the more predatory
private equity funds
and their mountains of aggressively used borrowed money.

This leads to a central issue for Larry in the current financial
world - that many of the new products and financial 'developments' have
created ways to simply transfer wealth en masse from stockholder and pension fund investor to financiers.

In short, if you have an interest in finance or a desire to understand more about the workings of the world, he is a very interesting man!

After our conversations, I find it difficult to believe that it
can be anything other than a revelation of facts about the mismanagement
of global and corporate finance. You can visit Larry's website
here.

In his book, he describes the months leading up to Lehman
Brothers bankruptcy from his position within the company. In his job, he
was looking for assets and companies that were likely to fall in price
and it was his job to profit from those falls.

Tellingly, he spotted a number of opportunities in the US
sub-prime mortgage market which he was able to trade on and make a
profit for the bank. This was rather ironic though since his colleagues
in the mortgage division were busy buying, repackaging and selling
mortgage assets. Their exposure was so great that it caused Lehman
Brothers stock to drop dramatically in price, putting the company under
terrible pressure.

An issue that Larry brings up in the book was that while he and a couple of colleagues were selling mortgage assets short in fairly limited numbers, their colleagues on another floor had turned the bank into the equivalent of a sub-prime mortgage factory. No matter how much he sold and was proven to be correct, other colleagues were getting the bank into much bigger trouble, much faster.

Meanwhile, Lehman Brothers CEO and top management team were busy
trying to take on more risk, despite already having leveraged their
balance sheet to almost 50 to 1. As other Wall Street investment banks
started to really struggle - most notably Bear Stearns - the Lehman
Brothers news was bad enough that it kept pulling them further into
trouble.

Bear Stearns was ultimately bought for a song by JP Morgan Chase,
but the other major investment banks - such as Goldman Sachs and
Merrill Lynch - could not be convinced to save Lehman Brothers. At the
same time, the US government faced a terrible dilemma since the world's
largest insurer, AIG, was also in deep financial trouble. Not having the
money to rescue both institutions, the American government chose to
save AIG and let Lehman and the rest of Wall Street learn some harsh
lessons. In total the US government spent some $700 billion on the Wall
Street bailout.

Going down

After the fact, it was alleged by the former Lehman Brothers CEO
Richard Fuld and others that there had been significant short selling
and naked short selling (information here) of the bank's stock by it's Wall Street rivals. Whether or not this is
true, and in the kill or be killed world of investment banking it might
well be, these short sales would have had far less impact had the
balance sheet have been more sound. Typically, rumours of weakness are
based on something and in banking a loss of confidence quickly becomes a
self-fulfilling prophecy.

However, in the preceding 18 months or so, many banks (both
retail and investment) had seen their stock prices fall significantly on
capital markets around the world.

In the UK for example, both Bradford
and Bingley and Northern Rock were under terrible pressure. It is hard
to imagine that short selling by some investment banks and hedge funds
was not underway, but these funds did seem to have identified real
weaknesses in the business models of these banks. The short selling
reduced confidence in the banks, but ultimately their management team
took the decisions that made the institutions weak enough to become a
target.

These business model problems (mainly related to long-term lending with short-term borrowed financing) also caused HBOS (formerly the Halifax Building Society and the Bank of Scotland) to be forced onto Lloyds Bank. Normally we imagine huge mega mergers like this taking months for analysts to pore over the accounts and records. Not this time. One of the largest mergers in UK corporate history was essentially hashed out at a cocktail party with members of the government forcing them together. Really...

Most of Wall Street (information here) was using a measure known as VaR, or Value at
Risk. This was a calculation made at the end of every working day to
quantify the amount of risk being taken by the investment bank that day
in terms of US dollars. It was a guide to help management decide what
could and could not be done and offer a daily snapshot of the company's
balance sheet. With hindsight, it seems that too much faith was placed
in VaR and the method has faced wide criticism since.

Parts of Lehman were sold off at very short notice to Barclays
plc and Nomura Holdings amongst others. There was also a need to open
the derivatives market for an unprecedented three hours on a Sunday to
help unwind some of the trades and deals that the bank was involved in.
It was hoped that by doing this the entire financial system would not be
pulled under. Ultimately, it worked, though it did offer up many
financial assets at fire sale prices.

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